sign in sign up
<<
Home , Foreign tax credit, Tax Reform Act of 1976

A History of Controlled Foreign Corporations and the Foreign Credit by Melissa Redmiles and Jason Wenrich

Figure A s U.S. corporations have expanded their busi- nesses overseas in the last several decades, the Corporate Foreign , in Constant 2004 United States Tax Code has been modified to Dollars, Selected Tax Years 1925-2002 [1] A [Money amounts are in millions of dollars] account for increasingly complex international cor- porate structures and transactions. Two important U.S. Foreign tax Tax year Percentage international tax concepts that have emerged over before credits credit the years are the corporate foreign tax credit and (1) (2) (3) controlled foreign corporations. The corporate for- 1925...... 12,629 216 1.7 eign tax credit was created to alleviate the burden of 1930...... 8,054 328 4.1 1940...... 28,929 783 2.7 . The income of controlled foreign 1950...... 123,757 3,637 2.9 corporations has become increasingly subject to U.S. 1960...... 139,544 7,811 5.6 tax after initially presenting a potential tax deferral 1970...... 160,414 22,147 13.8 advantage over foreign branches. A brief history of 1980...... 238,030 57,037 24.0 the foreign tax credit and controlled foreign corpora- 1990...... 172,617 36,115 20.9 292,106 53,210 18.2 1 2000...... tions is presented below. 2004...... 299,555 56,872 19.0

[1] For comparability, money amounts have been adjusted for inflation to 2004 constant Corporate Foreign Tax Credit dollars. The United States generally U.S. companies on their worldwide incomes. Since other countries payroll taxes, can be deducted from foreign-source may also impose a tax on income earned within their income but not credited. Income taxes paid to a lo- borders, U. S. companies with foreign-source income cal authority, such as a province, are eligible for the face potential double taxation. When the income credit. Taxes paid for a specific right or service, like tax was first created, Congress addressed this issue a royalty payment for the right to mine, generally by allowing taxpayers to deduct their foreign taxes cannot be credited. After the Technical Amendments when computing . In 1918, after the Act of 1958, taxpayers could carry their unused for- cost of World War I pushed up both domestic and eign taxes forward for 5 years or back for 2. Figure many foreign tax rates, Congress passed the foreign A shows foreign tax credit amounts for select years tax credit provisions to provide greater relief in cases between 1925 and 2004, in constant 2004 dollars. of double taxation. These provisions permit taxpay- U.S. companies generally are not taxed on the ers the option of either deducting their foreign taxes earnings of their foreign subsidiaries until those earn- when computing their taxable incomes or taking a ings are distributed to the parent company, and thus dollar for dollar credit for them against their U.S. tax cannot claim a direct credit for the foreign taxes paid liabilities. Corporations report the foreign income by the subsidiary. The foreign tax credit provisions, and taxes related to the credit on Form 1118, Compu- however, allow taxpayers an indirect credit for the tation of Foreign Tax Credit—Corporations. foreign “taxes deemed paid.” Taxes deemed paid are computed as a share of the foreign taxes on the Creditable Taxes earnings out of which the distribution was made pro- To be eligible for the credit, the tax paid had to be a portionate to the ratio of the distribution to the total foreign income tax. Although the precise definition earnings. To be eligible for the indirect credit, the of a foreign income tax has changed somewhat over U.S. company must own a certain percentage of the the years, the basic idea remains today. Other taxes, foreign subsidiary’s voting stock. In 1962, the own- such as value-added taxes, , property, and ership percentage was lowered from the original 50 percent to 10 percent. Until 1976, taxpayers could Melissa Redmiles and Jason Wenrich are economists with the claim the credit down to the second tier of owner- Special Studies Returns Analysis Section. This article was ship, as long as the second tier corporation was at prepared under the direction of Chris Carson, Chief. least 50-percent owned by the first tier corporation.

1 For a more detailed description of , see Doernberg, Richard L. (1999), International Taxation, West Group, St. Paul, MN. 129 A History of Controlled Foreign Corporations and the Foreign Tax Credit

The Act of 1976 expanded the level of investments abroad to generate additional, low-taxed ownership to three tiers and changed the percentage foreign income that could be combined with higher requirements to 10 percent for all tiers, provided that tax income.2 the combined percentage ownership of all tiers is at Congress placed further restrictions on the for- least 5 percent. Congress gradually expanded the lev- eign tax credit in the Tax Reduction Act of 1975 and el of ownership down to six tiers, but the 5-percent the Tax Reform Act of 1976. These laws eliminated rule remains in effect. the per country limitation option and added a new limitation category, dividends from a Domestic In- Limitations and Reductions ternational Sales Corporation (DISC).3 Income that As originally enacted, the foreign tax credit had a did not fit into the interest category or DISC dividend major drawback. Since companies could credit an category fell into an overall or general limitation cat- unlimited amount of tax paid to countries with tax egory. This legislation also introduced a reduction in rates that exceeded the U.S. rate, they could off- credit for taxes paid on foreign oil and gas extraction set some of their tax on domestic income with the income equivalent to the amount of foreign taxes credit for taxes on foreign income. To remedy this, paid, accrued, or deemed paid on foreign oil and gas Congress added a limitation to the foreign tax credit extraction income that exceeded a certain percentage in the . The limitation essen- of foreign oil and gas extraction taxable income. The tially caps foreign taxes credited to the U.S. rate, percentage has changed over time and is currently by limiting the amount of credit to a corporation’s set at the highest rate of , 35 percent for U.S. income tax liability multiplied by the ratio of Tax Year 2006. In addition, the 1976 Act included foreign-source income to worldwide income. When boycott legislation. Now, taxpayers who agree to first enacted, taxpayers computed the limitation us- participate in an unsanctioned boycott may need to ing total foreign-source taxable income. A limitation reduce their foreign credits or their foreign taxes eli- computed using this method later become known as gible for credit. an overall limitation. Finally, these laws added an overall foreign loss One problem with the limitation was that taxpay- recapture. The intent of the overall loss recapture ers could still offset some domestic tax liability by was to limit the amount of domestic tax liability that combining amounts of income earned in high-tax could be offset by foreign losses. Before this legisla- countries with income in low-tax countries, in their tion, if a taxpayer had an overall foreign loss in one computation of the credit limitation. What, if any- year and an overall foreign gain in a subsequent year, thing, should be done about this issue has been the the taxpayer could use all of his or her foreign-source driving force behind much subsequent foreign tax taxable income in the year with the gain in comput- credit legislation. Beginning in 1932, Congress re- ing the foreign tax credit limit. Since 1976, in the quired taxpayers to compute the limitation on a per years when taxpayers have an overall foreign gain, country basis. In addition, the sum of all allowable they must treat the smaller of all overall losses from credits from all countries could not exceed the overall previous years or 50 percent of their current foreign- limitation. The latter requirement was removed from source income as domestic source income. the in 1954. Public Law 86- In 1985, the Treasury Department recommended 780, enacted in 1960, granted taxpayers the ability reinstating the per country limitation. U.S. compa- to elect either an overall limitation or a per country nies with substantial foreign-source income objected, limitation. In 1962, Congress introduced a separate and Congress compromised by greatly expanding the limitation for nonbusiness-related interest. This categories of income requiring a separate limitation prevented taxpayers from making interest-bearing in the .4 Beginning with Tax

2 Andersen, Richard E. (1996), Foreign Tax Credits, Warren, Gorham & Lamont, Boston, MA. 3 Dividends from a DISC or former DISC refer to dividends from a Domestic International Sales Corporation (DISC) that are treated as foreign-source income. A DISC is a small domestic corporations whose activities are primarily exported-related. A portion of the DISC’s income was not subject to tax until it was distributed to shareholders. Tax advantages of DISCs were repealed in 1984. 130 4 Gustafson, Charles H.; Robert J. Peroni; and Richard Crawford Pugh (2001), Taxation of International Transactions, Materials, Text and Problems, West Group, St. Paul, MN. A History of Controlled Foreign Corporations and the Foreign Tax Credit

Year 1987, the limitation categories included: general ing stock together own 50 percent or more of either limitation income, passive income, high withholding the voting stock or the value of the stock. A separate tax interest, financial services income, shipping in- limitation had to be computed for each noncontrolled come, dividends from a DISC, taxable income attrib- corporation. If the foreign corporation did not meet utable to foreign income, certain distributions the definition of a 10/50 company, the dividends from a Foreign Sales Corporation (FSC) or former were placed into a limitation category based on the FSC, section 901(j) income, and dividends from each type of income that generated the dividends. These noncontrolled foreign corporation.5 provisions are often referred to as the look-through Passive income generally includes dividends, rules. Congress has since phased out the separate net capital gains, interest, rents, royalties (except for limitation on each noncontrolled corporation basket. rents and royalties derived in an active trade or busi- Now these dividends are categorized according to the ness from an unrelated person), annuities, and certain look-through rules. commodities transactions. Passive income subject In 1988, a new category, income resourced by to an effective foreign that is greater than the treaty, was added. It refers to income that would oth- highest U.S. corporate rate must be “kicked out” to erwise be considered domestic income that has been the general limitation category. High withholding tax resourced to foreign source per provision. interest is interest income subject to a withholding Taxpayers must compute a separate limitation for rate of 5 percent or more. (An exception exists for each occurrence where income has been resourced. interest received in the conduct of financing certain activities.) Financial services income pertains Recent Changes to a company whose gross income is composed of The most recent major revision of the foreign tax 80 percent or more of financial services income. It credit provisions was the American Jobs Creation includes income derived from the active conduct Act of 2004. The law adjusts how taxpayers cal- of banking, insurance or financing, export financ- culate the foreign tax credit for the purposes of the ing interest excluded by the exception from the high . It also modifies the rules withholding interest basket, and other income related that govern how companies allocate their interest to financial services income. Shipping income is expenses between foreign and domestic incomes so income related to that industry. Taxpayers cannot that multinational corporations will be able to allo- claim a credit for taxes paid or accrued by a Foreign cate less interest to their foreign-source incomes, and Sales Corporation (FSC) on its taxable income attrib- thus increase their foreign tax credit limitations. The utable to foreign trade, as defined by Internal Rev- new law adds an overall domestic loss recapture that enue Code section 923(b), and must compute a sepa- complements the rules on overall foreign loss. Now, rate limitation on such income. Distributions from a if a taxpayer is unable to take a foreign tax credit FSC include distributions from the earnings and prof- during a year with foreign gains but an overall loss, its of the FSC’s foreign trade income and interest and the taxpayer will be able to resource some of the carrying charges from transactions that create foreign domestic income to foreign income in a subsequent trade income. Section 901(j) countries are those con- year, which will increase the foreign tax credit limi- sidered hostile to the United States.6 Taxpayers must tation. Next, the carryback period for foreign taxes calculate a separate limitation for each section 901(j) in excess of the limitation has been reduced to 1 year, country and may not credit any taxes paid to them. while the carryforward period has been increased to Dividends from a noncontrolled foreign cor- 10 years. Finally, the separate limitation categories poration were defined as dividends from foreign will be reduced to four: passive income, general subsidiaries of which the U.S. corporation owns limitation income, section 901(j) income, and income at least 10 percent of the voting stock and the U.S. resourced by treaty. These provisions will be fully shareholders who own at least 10 percent of the vot- implemented by Tax Year 2009.

5 A Foreign Sales Corporations (FSC) is a company incorporated abroad, created to promote U.S. and usually controlled by a U.S. person. A portion of the FSC “foreign trade income” was exempt from U.S. taxation. Congress repealed the FSC provisions in 1999 and the transition rules that permitted some FSC activity to continue in 2006. 6 Current Section 901(j) countries include Cuba, Iran, North Korea, Sudan, and Syria. 131 A History of Controlled Foreign Corporations and the Foreign Tax Credit

Figure B U.S. Corporations and Their Controlled Foreign Corporations, 1962-1980, Selected Years (Money amounts are in thousands of dollars) Controlled Foreign Corporations Dividends paid to Number of domestic Number Net current earnings and Foreign income Tax year domestic corporations corporation returns [1] of returns [2] profits after taxes [3] and profits taxes filing Form 2952 (1) (2) (3) (4) (5) 1962...... 2,642 12,073 2,558,999 1,622,282 1,133,348 1965...... 3,513 17,668 3,564,260 2,168,369 1,457,561 1966...... 3,732 19,617 4,453,291 2,533,206 1,525,137 1980...... 4,799 35,471 31,181,131 16,440,451 14,172,649 [1] For 1962, both active and inactive domestic corporation returns with Form 2952, Information Return with Respect to Controlled Foreign Corporations, are included. For 1965, 1966, and 1980, only active domestic corporation returns are included. [2] For 1962, domestic corporations were required to report for only two tiers of foreign ownership. For 1965, 1966, and 1980, the reporting requirement was for at least three tiers of foreign ownership. [3] For 1962, this was reported as "Net profit before taxes" on Form 2952. For 1965, 1966, and 1980, "current earnings and profits after foreign income and profits taxes" were required to be reported on Form 2952.

Controlled Foreign Corporations The penalty for failing to timely file a Form 2952 for The history of controlled foreign corporations in each CFC was a 10-percent reduction of foreign tax United States is characterized by reduction of credits attributable to all foreign corporations or their the tax deferral advantages of United States corpora- foreign subsidiaries. tions operating businesses overseas through foreign Initially, foreign income earned by CFCs was not corporations. Four major pieces of legislation have taxable to the U.S. shareholder until it was repatri- defined and extended the concept of a controlled ated to the United States in the form of a dividend. foreign corporation and the mechanism by which for- This is in contrast to foreign operations conducted eign corporation earnings are includable in the U.S. through a foreign branch whose income was taxable shareholder’s taxable income. to the U.S. corporation when it was earned. U.S. In the aftermath of World War II, political and corporations could maximize the tax deferral op- economic developments, such as the Marshall Plan, portunity of foreign corporations by organizing their encouraged international expansion by U.S. busi- international structures and transactions with foreign nesses. Congress enacted Public Law 86-780 in subsidiaries in such a way as to accumulate profits 1960 in part to obtain information on the overseas in foreign corporations organized in low-tax coun- activities of U.S. corporations. This law required tries and repatriate the earnings in years when the each U.S. corporation to provide, as a part of its tax U.S. parent corporation had losses or excess foreign return, information on all foreign corporations di- tax credits. Additionally, when U.S. corporations rectly-controlled by the U.S. corporation (“first-tier” disposed of their stock in CFCs the tax-deferred ac- subsidiaries) and any foreign corporations controlled cumulated earnings and profits of the foreign corpo- by a directly-controlled foreign corporation (“sec- ration could be repatriated to the United States at the ond-tier” subsidiaries). A controlled foreign corpora- lower rate. tion (CFC) was defined as any foreign corporation The reduced the tax defer- in which more than 50 percent of the voting stock ral advantages of CFCs by refining the concept of a was directly owned by one or more U.S. corpora- “controlled” foreign corporation and by adding Sub- tions on any day of the taxable year of the foreign part F to the Internal Revenue Code. The 1962 Act corporation. A controlled “second tier” subsidiary redefined a foreign corporation as controlled if more was defined as a foreign corporation in which more than 50 percent of the voting stock of the foreign cor- than 50 percent of the voting stock was owned by a poration was owned by U.S. shareholders for an unin- directly-controlled foreign corporation. Information terrupted period of 30 days or more during the foreign on first- and second-tier CFCs was reported on Form corporation’s tax year. For purposes of determining 2952, Information Return by a Domestic Corporation control, the voting stock of only those U.S. share- with Respect to Controlled Foreign Corporations. holders owning at least 10 percent of the voting stock 132 A History of Controlled Foreign Corporations and the Foreign Tax Credit

Figure C

U.S. Corporations with Total Assets of $250 Million or More and Their Controlled Foreign Corporations, 1976-1984, Selected Years (Money amounts are in thousands of dollars) Controlled Foreign Corporations Number of Current earnings and Tax year U.S. corporation Number Foreign income taxes Total Total Subpart F profits (less deficit) returns of returns (net) distributions income before taxes (1) (2) (3) (4) (5) (6) 1976...... 757 21,071 23,478,736 8,814,825 6,569,018 822,674 1982...... 1,034 26,993 36,696,077 14,077,332 14,650,375 4,466,139 1984...... 1,103 27,008 48,591,785 19,663,431 17,429,494 4,420,024 of the foreign corporation was included. Attribution The most significant effect of the Revenue Act rules were introduced in the 1962 Act to account for of 1962 for controlled foreign corporations was the various ownership structures that would otherwise introduction of Subpart F to the Internal Revenue avoid the requirements for declaring a foreign corpo- Code. The Subpart F inclusion rules restricted U.S. ration a controlled foreign corporation. For example, shareholders’ ability to defer taxes on certain types if 6 individuals each wholly owned a separate U.S. of income by requiring the income to be included in corporation, and, in turn, the individuals and their re- the U.S. shareholders’ current-year taxable incomes spective corporations each owned an equal amount of regardless of their repatriation to the United States. voting stock of a foreign corporation, in the absence The pro rata share of foreign income includable in of attribution rules, the foreign corporation would not the U.S. shareholder’s income consisted of Subpart F be a CFC. By attributing the voting stock of the for- income, previously excluded Subpart F income with- eign corporation owned by each U.S. corporation to drawn from investments in less-developed countries, its individual owner, the 10-percent voting stock own- increases in investment of earnings of CFCs in Unit- ership threshold would be met for each U.S. share- ed States property, and previously excluded Subpart holder, and, collectively, all U.S. shareholders would F income withdrawn from export trade corporation own more than 50 percent of the voting stock of the assets (these categories are collectively referred to as foreign corporation. The foreign corporation in this “Subpart F income”). The majority of Subpart F in- example would be a “controlled” foreign corporation come is made up of “passive” income like dividends, and would be required to file Form 2952. interest, royalties, and rents and income derived from The 1962 legislation also increased the Form insurance of United States risks. U.S. shareholders 2952 filing requirement by extending the definition were not required to include their pro rata shares of of a controlled foreign corporation to include any Subpart F incomes in their taxable income if the Sub- foreign corporation within a chain of control. A U.S. part F income accounted for 30 percent or less of the shareholder was “deemed” to control an unlimited CFCs gross income or if distributions of the CFCs number of lower-tier foreign corporations when it income were made so that the combined payment of owned more than 50 percent of the voting stock of foreign and U.S. taxes were 90 percent or more of a first-tier corporation which owned more than 50 the U.S. rate. Since Subpart F income is generally percent of the voting stock of a second-tier corpora- includable in the U.S. shareholder’s taxable income tion, and so forth. Additionally, the Form 2952 filing when it is earned, no additional U.S. tax is imposed requirement was extended to include not only U.S. when it is repatriated to the United States. Finally, corporations but U.S. citizens and residents, domestic the 1962 Act restricted the conversion of tax-deferred partnerships, estates, and trusts, as well. The penalty earnings into capital gains for purposes of repatriat- for failing to timely file Form 2952 was amended to ing the income at the lower capital-gain tax rate. a reduction of the foreign tax credit in the amount of The Tax Reduction Act of 1975 expanded what the greater of $10,000 or the income of the foreign constituted Subpart F income and increased the corporation with respect to which the reporting fail- likelihood that such income would be included in a ure occurred. U.S. shareholder’s taxable income. Some types of 133 A History of Controlled Foreign Corporations and the Foreign Tax Credit

Figure D U.S. Corporations with Total Assets of $500 Million or More and Their 7,500 Largest Controlled Foreign Corporations, 1986-2002, Selected Years (Money amounts are in thousands of dollars) Controlled Foreign Corporations [1] Number of U.S. Current earnings and Tax year Foreign income Distributions from Subpart F corporation returns profits (less deficit) before taxes (net) earnings and profits income taxes (1) (2) (3) (4) (5) 1986...... 714 56,590,619 19,229,025 21,730,762 4,223,316 1988...... 744 79,811,427 23,929,652 45,524,746 12,101,074 1990...... 731 88,688,406 23,936,971 46,429,916 17,841,936 1992...... 749 69,613,140 18,471,643 42,971,551 13,217,040 1994...... 801 98,427,640 23,267,744 50,383,707 16,317,803 1996...... 890 141,010,411 32,394,527 68,813,441 22,943,983 1998...... 996 143,840,451 34,744,726 74,188,419 20,238,440 2000...... 1,087 207,576,012 43,143,111 94,882,197 29,372,318 2002...... 1,079 200,670,364 38,610,284 97,011,345 31,420,940 [1] This figure presents data for the largest 7,500 Controlled Foreign Corporations (CFCs) ranked by assets owned by U.S. corporations with $500 million or more in total assets. The largest CFCs are selected independently for each tax year study.

shipping income received by CFCs were added to the the total value of all shares of stock is owned by one definition of Subpart F income. The 1975 Act also or more U.S. persons (including U.S. corporations, lowered the Subpart F percentage of a CFCs gross partnerships, trusts, and estates). Only the voting income necessary for Subpart F income to be taxable stock of those U.S. persons directly, indirectly, or to the U.S. shareholder from 30 percent to 10 per- constructively owning at least 10 percent of either cent. Minor amendments to the definition of Subpart the voting stock or value of the voting stock of the F income have occurred since 1975. foreign corporation is considered for purposes of de- Form 2952 was replaced in 1983 by Form 5471, termining if the 50-percent threshold is met. Information Return with Respect to Certain Foreign The American Job Creation Act of 2004 is the Corporations.7 Form 5471 significantly increased most recent piece of legislation affecting controlled the amount of information required to be reported for foreign corporations. This act, in an effort to encour- each controlled foreign corporation, although not all age U.S. corporations to repatriate their accumulated filers were required to complete all schedules. Form foreign earnings and reinvest them in U.S. projects, 5471 included an expanded income statement sched- allowed for a one-time 85-percent dividends received ule, a cost of goods sold schedule, a foreign taxes deduction for cash dividends received from con- paid schedule, a balance sheet schedule, and earnings trolled foreign corporations. To receive this deduc- and profit analysis schedules. tion, the U.S. corporation must have had a qualified The Tax Reform Act of 1986 again refined the reinvestment plan and receive the cash dividends in controlled foreign corporation concept in part to ad- the U.S. corporation’s last tax year beginning before dress the issue of U.S. shareholders transferring 50 October 22, 2004, or the first tax year beginning in percent of the voting stock of a foreign corporation the 1-year period after that date. to “friendly” foreign shareholders and avoiding the Statistics of Income (SOI) has collected data “controlled foreign corporation” designation while on Forms 2952 and 5471 every other tax year since still maintaining 50-percent voting stock of the cor- 1962. In Tax Year 1962, there were 12,073 Forms poration and most of the value. The 1986 legislation 2952 filed by 2,642 United States corporations.8 In expanded the definition of a CFC to include foreign Tax Year 2002, there were 75,579 Forms 5471 filed corporations for which 50 percent or more of the vot- by 2,119 U.S. parent corporations with $500 million ing power of all classes of stock entitled to vote or or more in assets.9 Figures B, C, and D include

7 In addition to Form 2952, Form 5471 replaced Form 957, U.S. Information Return by an Officer, Director, or U.S. Shareholder of a Foreign Personal Holding Company, Form 958, U.S. Annual Information Return by an Officer or Director of a Foreign Personal Holding Company, Form 959, Return by an Officer, Director, or Shareholder With Respect to the Organization or Reorganization of a Foreign Corporation and Acquisition of Its Stock, and Form 3646, Income from Controlled Foreign Corporation. 8 Foreign Income and Taxes, Corporation Income Tax Returns (Publication 479), Statistics of Income, April 1973. 134 9 Based on unpublished data. A History of Controlled Foreign Corporations and the Foreign Tax Credit

additional information from SOI studies covering data collected from all Forms 2952 filed by U.S. par- this period. ent corporations in the Statistics of Income corporate sample. For Tax Years 1974, 1976, 1982, and 1984, Data Sources and Limitations data were collected from Forms 2952 filed by U.S. Two of the largest studies of international income parent corporations with greater than $250 million in and taxes conducted by Statistics of Income are the total assets. Population estimates were again tabu- Corporate Foreign Tax Credit and Controlled Foreign lated for Tax Year 1980. For Tax Years 1986 through Corporation studies. The foreign tax credit studies 2002, data were collected for all Forms 5471 filed are derived from returns in the corporation Statistics by U.S. parent corporations with greater than $500 of Income sample. The foreign tax credit is under- million in total assets. During these years, data were stated to the extent that it does not include foreign published for the largest 7,500 controlled foreign taxes carried back. corporations ranked by assets. The Controlled Foreign Corporation study, usu- Data for both studies do not include adjustments ally conducted every other tax year, has changed made during audit. Data for recent study years can since the first study conducted for Tax Year 1962. be found on the Statistics of Income Web site Initially, population estimates were tabulated using (www.irs.gov/taxstats).

135